COST OF DEBT NOTES & PROBLEMS

1. As an investment manager you are given the following information: Investment in equity shares of Cement Ltd. Steel Ltd. Liquor Ltd. Government of India Bond Initial Price (Rs.) 25 35 45 1000 Dividends (Rs.) 2 2 2 140 Year end market price (Rs.) 50 60 135 1005 Beta risk factor 0.8 0.7 0.5 .99

Risk free return: 8 %. You are required to calculate i) expected rate of retuen of market portfolio, and ii) expected return in each security, using CAPM.

2. A firms after tax cost of capital of the specific sources is as follows: Cost of debt Cost of preference shares (incl. dividend distribution tax) Cost of equity funds The following is the capital structure: Source Debt Preference Capital Equity Capital Amount Rs. 3,00,000 Rs. 2,00,000 Rs. 5,00,000 8 percent 14 percent 17 percent

Calculate the weighted average cost of capital, k0, using book value weights. 3. The Elu Limited is contemplating a debenture issue on the following terms: Face value: Term of maturity Rs. 100 per debenture 7 years

Yearly coupon rate of interest Years 12 34 9 percent 10 percent

57

11 percent

The current market rate on similar debentures is 11 percent per annum. The company proposes to price so as to yield a (compounded) return of 12 percent per annum to the investors. Determine the issue price. Assume redemption at a premium of 5 percent on the face value.

4. A companys debentures of the face value of Rs. 100 bear an 8 percent coupon rate. Debentures of this type currently yield 10 percent. (a) What is market price of debentures of the company? (b) What would happen to the market price of debentures if interest rate rises to (i) 16 percent, and (ii) drops to 12 percent? (c) What would be market price of debentures in situation (a) if it is assumed that debentures were originally having a 15 percent maturity period and maturity period is 4 years away from now? (d) Would you pay Rs. 90 to purchase debenture specified in situation (c)? Explain.